Is the Technology Sector Overvalued?

The technology sector has become a more significant part of the US stock market in recent years. It’s now the largest sector in the S&P 500 index, and four out of the ten biggest companies by market value—Apple, Microsoft, Facebook, and Alphabet (the parent company of Google)—are technology companies. A fifth, Amazon.com, is a retail/technology hybrid. For some investors this growth brings back painful memories of the dot-com bubble of the late 1990’s and the subsequent crash. Are technology stocks once again overvalued?

There are a number of key differences between the current situation and the dot-com bubble. While in the 1990’s many technology stocks became worth tens of billions or even hundreds of billions of dollars with minimal profits, large technology companies today are much more profitable and valuations are generally more reasonable. And the technology sector overall hasn’t even performed that well. Over the past five years technology has the third-lowest returns among the ten sectors of the stock market, ahead of only materials and energy.

There are also dramatic valuation differences within the technology sector. Using the price-to-earnings (or “P/E”) ratio, a common valuation metric, there are certainly some tech companies that seem to have high valuations. Alphabet (P/E ratio of 33), Facebook (P/E ratio of 89), and Amazon.com (P/E ratio of 509) all have stock prices that are fairly high compared to their profits, especially for such large companies. But there are also large tech companies closer to the other end of the valuation spectrum. Apple and IBM have P/E ratios of about 11 while Cisco and Intel have P/E ratios of about 14.

So is it safe to at least say that the companies like Alphabet and Facebook are overvalued? Not necessarily. Alphabet, for example, is working on projects such as self-driving cars and anti-aging technologies. If these kinds of potentially revolutionary projects pay off, its current stock price could end up seeming like a bargain. The same is true of other companies with similarly grand ambitions such as Facebook (which is working on artificial intelligence and virtual reality), and Amazon (which is working on drone delivery and other logistics innovations).

For investors, however, these potential innovations aren’t unequivocally good. Innovations that benefit one company often come at the expense of others. Apple’s success with the iPhone, for example, hurt companies such as Nokia, Microsoft, Dell, and HP. Similarly Facebook’s dominant social network has hurt companies such as Alphabet and Yahoo. That reality suggests even if valuations aren’t outlandish for the technology sector overall, at least some of the large tech companies with high valuations will inevitably prove to be disappointments.